Thursday, October 2, 2014

India Strategy

Indian cap goods: Rising relevance of globalization

Expectations of quick revival in investment cycle are pivoted upon expeditious project clearances and execution under the new government. However, the fact that clearances of 152 projects worth Rs 5.3tn (5% of GDP) by the previous government failed to reinvigorate private investment suggest factors outside of the ambit of clearances may be more relevant.
The fundamental hindrances are slow to thaw: Agnostic to governments, private investments are a function of sales growth, return on capital, cost of doing business, balance sheet strength and operating leverage on the one hand and the Saving-Investment mismatch on the other. These variables have still not moved much over the past three months; the land acquisition bill still stands intact and reforms in labor law looks distant.
See no immediate revival in investment cycle: After analysing the structural and cyclical indicators and based on empirical evidence*, we feel that expectations of a turnaround in the domestic investment cycle are premature. The following are a few relevant observations-
n       New investment projects started have halved from Rs 1.8 tn a year ago to Rs 900 bn in Q1FY15 with a steep increase in investment projects dropped.
n       Slowdown in non-food credit growth to sub 10% and decline in sales growth for non-finance companies to 4.7% in FY14 from 9.1% in FY13 are fairly strong evidence to portend weak private sector investment in FY15.
n       Decline in non-food credit growth possibly reflects tightening credit conditions (regulatory or initiated by banks) and can sustain asset quality concerns.
Till the fundamentals adjust adequately, we believe that domestic investment cycle will meander around low growth trajectory, if not weaken further. As of now nothing has changed on the ground. Most companies we met believe that it will be around 18 months before investment cycles start turning around.
Increasing significance of global business for domestic Cap goods: We have observed that domestic capital goods companies across market caps and regions are aggressively looking to diversify into global tenders and businesses, rather than continuing to concentrate on domestic industry; a trend we believe could be structural in nature. In developed markets, companies are engaging in arrangements to neutralize the lack of acceptance of made in India brand. In general, sales breakup of capital goods companies suggest an increasing proportion of global businesses. Strikingly, capital goods export/imports has risen to 70% in FY14 from 33% in FY08.
Investment theme: Prefer global businesses with high product plays
We believe that the general market enthusiasm regarding in capital goods companies may be a bit exaggerated. Exports of capital goods/capital goods imports has risen from a low of 33% in FY08 to 70% in FY14, thereby extending the structural reliance on global market since FY96 when the ratio was at a low of 20%. We believe businesses having significant share of global revenues with product plays deserve higher valuations. Our stock picks are driven by a) Business model –bias in favour of product companies with increasing share of export revenues, b) business visibility, c) balance sheet strength, d) cash flows, and e) RoCE. Our conviction buys are Symphony, TD Power Systems, LMW and Cummins. But based on our export-product-EPC matrix we also like companies such as ABB India, Alstom T&D, Siemens, KEC International and Kalpataru Power. In the large caps we maintain our preference for L&T and avoid view on BHEL.